Obama Should Tell California
to Drop Dead

Peter Schiff
May 30, 2009

During the height of New York
City's financial crisis in the 1970's, President Gerald Ford
had the good sense to turn down Mayor Abe Beame's request for
a federal bailout. The refusal prompted the famous New York Post
headline, "Ford to City: Drop Dead." More than 30 years
later, as California Governor Arnold Schwarzenegger makes a similar
plea to Washington, I hope President Obama will show similar
restraint. Unfortunately, given Obama's recent string of unwise
economic decisions, it's hard to imagine that his judgment will
suddenly improve.

A federal bailout would spare
California from having to make spending cuts needed to bring
its budget into balance. The matter has become urgent since California
voters rejected several tax-hiking ballot initiatives. Rather
than taking the vote as a signal to dramatically curtail spending,
the state turned to the feds. If they get a free pass, the politicians
can avoid fixing any of their past mistakes or preparing California
for the future.

California, like many states,
expended its bureaucraacy as the nation's bubble economy inflated.
When condos flipped like hamburgers and homeowners flush with
equity spent like lottery winners, extra tax revenue flooded
into Sacramento. However, instead of saving the money for a rainy
day or paying off prior debts, the state government simply ballooned
its spending. Now that the bubble has burst, and revenues are
severely depleted, it is time for California to reconsider its
excesses.

Governor Schwarzenegger's claim
that a federal guarantee is not a bailout is ludicrous. No one
in the private sector will lend California any money because
the state can't pay it back. Just like AIG and GM, it needs federal
help to stay solvent. And although the Federal balance sheet
is in far worse shape than California's, there is one crucial
difference: Washington has a printing press, and Sacramento does
not. With the ability to pay off debts with newly created funds,
a federal default is not a concern.

However, if Obama comes to
the rescue, none of the needed cuts will be made. Instead, California
will continue to operate its bloated bureaucracy and will be
in constant need of more bailouts. In other words, if Schwarzenegger
gets his bailout, look for him to utter his famous line - "I'll
be back."

But it's not just Schwarzenegger
who will be back, but governors from all the other states as
well. After all, if the Federal government bails out California,
by what right can they deny similar aid to other states? The
bailout will send a clear message that states do not need to
cut spending.

Similar to the reckless behavior
that resulted from federally guaranteed mortgages, federal guarantees
on state debt will counteract the market's attempt to force states
to act responsibly. As the market accurately prices-in the heightened
risk of default, California faces staggering increases in its
borrowing cost. Under normal circumstances, this pressure would
force the state to act prudently now to diminish the risk of
a future default. However, by allowing California to evade the
"bond market vigilantes," the stage will be set for
much bigger losses.

The moral hazards created by
state bailouts are tremendous. With federal guarantees given
to profligate states, those states that had shown greater fiscal
responsibility will face higher interest rates - as their bonds
lack a federal guarantee. This creates the perverse incentive
for all states to act irresponsibly.

Just as government-guaranteed
mortgages lead the market to make overly risky home loans, federally
guaranteed state obligations will set the stage for yet another
crisis.

Federal backing of California
bonds would effectively turn them into Treasury bonds, with the
added appeal of being exempt from California state income tax.
Therefore, the Treasury will be at a competitive disadvantage
when it looks to issue its own debt to Californians. If it then
has to guarantee the bonds of all the other 50 states, why would
any Americans buy Treasuries when they can get identical credit
quality on better terms from the states? The only real buyers
left would be foreigners, who are already queasy about the Treasuries
they own.

The need to make good on state
and federal obligations will further depress the appeal of all
U.S. dollar-denominated debt. As a result, as real buyers flee
the market, the Fed will have to run its printing presses even
faster to pick up the slack. This will set into motion a self-perpetuating
spiral of money printing and Treasury sales with a predictable
result: hyperinflation.

In the meantime, by redirecting
credit to California that otherwise would have gone to more credit-worthy
borrowers, the government will worsen the credit crunch for the
rest of the country. Since there is only a finite supply of credit,
money borrowed by California will no longer be available to other
borrowers. The effect is a less efficient allocation of capital
that further undermines national productivity.

The only rational policy choice
for Obama is to send Schwarzenegger packing. If he does, California
will have no choice but to cut spending or default on its bonds.
My guess is that, with their backs to the wall, the California
legislature will choose the former. However, even if they default,
at least the losses will be borne by those who freely assumed
the risks. With a bailout, the losses will be shouldered by those
who were not even parties to the transactions. If we go this
route, we can all say "hasta la vista, baby" to our
prosperity.

For a more in depth analysis of our financial problems and the
inherent dangers they pose for the US economy and US dollar,
you need to read Peter Schiff's 2008 bestseller "The
Little Book of Bull Moves in Bear Markets" [buy
here] And "Crash Proof 2.0: How to Profit from the
Economic Collapse" [buy
here]

For a look back at how Peter
Schiff predicted the current crisis, read his 2007 bestseller
"Crash Proof: How to Profit from the Coming Economic
Collapse" [buy
here]

More importantly, don't wait
for reality to set in. Protect your wealth and preserve your
purchasing power before it's too late. Discover the best way to buy gold at
www.goldyoucanfold.com, and subscribe to
our free, on-line investment
newsletter.

Mr. Schiff is one of
the few non-biased investment advisors (not committed solely to
the short side of the market) to have correctly called the current
bear market before it began and to have positioned his clients
accordingly. As a result of his accurate forecasts on the U.S.
stock market, commodities, gold and the dollar, he is becoming
increasingly more renowned. He has been quoted in many of the
nation's leading newspapers, including The Wall Street Journal,
Barron's, Investor's Business Daily, The Financial Times, The
New York Times, The Los Angeles Times, The Washington Post, The
Chicago Tribune, The Dallas Morning News, The Miami Herald, The
San Francisco Chronicle, The Atlanta Journal-Constitution, The
Arizona Republic, The Philadelphia Inquirer, and the Christian
Science Monitor, and has appeared on CNBC, CNNfn., and Bloomberg.
In addition, his views are frequently quoted locally in the Orange
County Register.

Mr. Schiff began his investment career as a financial consultant
with Shearson Lehman Brothers, after having earned a degree in
finance and accounting from U.C. Berkley in 1987. A financial
professional for seventeen years he joined Euro Pacific
in 1996 and has served as its President since January 2000. An
expert on money, economic theory, and international investing,
he is a highly recommended broker by many of the nation's financial
newsletters and advisory services.